3. Rediscovering Classical Economics in the Laboratory

A perfect example is the Boston Haymarket, an historic outdoor greenmarket specializing in fruits and vegetables near Faneuil Hall, a public meeting house dating from colonial times, and therefore a popular community gathering place for the conduct of social, political, and therefore market affairs. Where people gather for any peaceful purpose, inevitably they also trade. Trade is everywhere a natural extension of human sociability.

This first edition source was not cited in any of the early experimental papers but is the edition available when the first experiment was conducted in January 1956.

Chamberlin (1948, p. 95) draws on the neoclassical tradition of both Jevons ([1871] 1988) and Edgeworth (1881). His experiments were “designed to illuminate a particular problem….that of the effect of deviations from a perfectly and purely competitive equilibrium [Jevons’ proposition] under conditions (as in real life) in which the actual prices involving such deviations are not subject to ‘recontract’ (thus perfecting the market) [Edgeworth’s construction] but remain final. The concept of a mechanism that allows equilibrium discovery before prices and contracts are binding has been reported in the experimental economics literature. This mechanism, “the uniform price double auction,” compares quite favorably in efficiency with the continuous double auction while making it possible for the market to find an equilibrium, before any contract becomes binding (Smith, 2008, pp. 84–98).

“This article reports on a series of experimental games designed to study some of the hypotheses of neoclassical competitive market theory” (Smith, 1962, p. 111). Skepticism, reflecting prevailing beliefs, is plain: “These schedules do nothing beyond setting extreme limits to the observable price-quantity behavior in that market. All we can say is that the area above the supply curve is a region in which sales are feasible, while the area below the demand curve is a region in which purchases are feasible…. We have no guarantee that the equilibrium defined by the intersection of these sets will prevail, even approximately, in the experimental market (or any real counterpart of it)” (Smith, 1962, p. 114).

At the start of trading in an experiment, and at the typical market opening on an Exchange, there is always a first bid or ask, and therefore public information is unilaterally volunteered by a private participant. Such action, however, is a challenge to the theory of optimal action. Optimality is conditional on information and none is public. This theory requirement seems irrelevant. Individuals appear to have a natural sense of being situated like others, a sample of one among N. Of course, once a market is ongoing, all have public information on yesterday’s closing price. These information challenges in experiments are at the opening, but they are a way of life in the organized commodity markets, where new “products” are routinely under consideration, and for which there is no yesterday’s closing price when they are first introduced.

That narrative, however, applies to one experiment reported in the Appendix by Smith (1962). Unlike the other experiments and the discussion in the text, in this experiment subject sellers were required to decide their production levels in advance, then inter or not the market with those inventories. The sunk-cost property of that experiment led to distress sales, low initial prices, and gradually increasing prices across successive trading periods, as sellers learned that buyers were willing to pay much higher prices than sellers were settling for initially. In effect, the product was perishable, as there is no provision in the experiment for allowing the carry-over of unsold inventories into the next period. Experiments that allow the carry-over of goods to future periods are reported by Smith and Williams (1984).

Marshall importantly clarifies and extends the concept of “natural,” or normal, supply price, which “is the real drift of that much quoted, and much-misunderstood doctrine of Adam Smith and other economists that the normal, or ‘natural,’ value of a commodity is that which economic forces tend to bring about in the long run” Marshall ([1890] 1920, p. 347).

Notice that in A. Smith’s specification, sellers need have no perception that price is “below equilibrium.” They simply experience the fact that when they bring Qs = Ǭ < Q* to market they find that buyers want to buy more (Qd) than the trucked amount, with each responding naturally in their own interest. Similarly, when they bring \(\ {\text{Qs}}^{\prime{}}\) > Q* to market, they cannot profitably dispose of it and cut (or accept a cut in) price. Each knows their own cost and, together with other sellers, know that market prices enable better or worse terms relative to those costs, and proceeds to adjust accordingly. Each may have beliefs, including conspiratorial beliefs that have no foundation, but each has tacit knowledge of what is to be done—Ryle (1946) calls it knowledge-how as distinct from knowledge-that.

Recall that in the experiments all goods (services) are non-durable and made to order (like sandwiches). Unlike A. Smith’s narrative we do not have sellers with inventories “brought to market;” all sellers are present and eager to sell in the market.

Value (willingness to pay or willingness to accept) is the (potential price) dependent variable as in Marshall, and in the experimentalists’ common representation of demand (supply). That is, quantity is the given independent variable, with value to be realized dependent on that quantity, and in the classical model where buyers arrive with values, sellers with costs and all are looking to determine prices. Total surplus, TS (P) imposes short-side rationing for quantities that support P ≠ P*, and the dynamic market response distinguishes demand unit value from supply unit cost. If P < P*, Q increases with entry as P increases; if \(\ {\text{P}}^{\prime{}}\) > P*, Q increases with entry as P decreases. Demand price exceeds supply price, and P becomes the independent variable in characterizing the market price adjustment effects, V (P) or TS(P).

Contrary to our postulate, if buyers were active at P, all those with wtp in the interval above P could profit from bidding above P.

Eventually, experimentalists defined an “institution” as consisting in the rules governing message exchange and outcomes (contracts in markets, majority rule in political contests, or terms of “agreement” in more general human governance arrangements). Smith (1964) is an early version of this broad scholarly exploration. In this use of the word, Martin Shubik is cited as the source—“the process of experimental design forces one to articulate rules and procedures, the collection of which forms an institution, organization, or ‘body of law’ with striking ‘real world’ parallels (cf. Shubik 1974). The laboratory becomes a place where real people earn real money for making real decisions about abstract claims that are just as ‘real’ as a share of General Motors” (Smith, 1976a, p. 275).

Later, studies of posted pricing only allowed price changes at the beginning of each period (Ketcham et al., 1984). In the text posted offer markets, the instructions allowed sellers to choose how often and who posted a freely chosen price. However, each new posted price displaced the previous posted price, and there was no requirement that the offers improve the terms for buyers. Later implementations of double-auction trading introduced bid/ask improvement rules and studied the effect of the various components of these rules on price discovery (Smith and Williams, 1983).